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Engineering the Financial Crisis

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Engineering the Financial Crisis

What were the 6 conventional reasons behind the financial crisis, and what are the arguments the authors make against each of these 6 reasons?

The six conventional reasons behind the financial crisis were:

  1. Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs), helped cause the crisis by relaxing their lending criteria and standards.
  2. Deregulation of finance allowed the financial entities other than commercial banks to originate subprime loans and securitize them.
  3. The compensation systems especially bonuses for revenue generating transactions encouraged bankers to bet huge amounts of borrowed money on the housing boom by buying mortgage-backed bonds. The bankers would be richly rewarded if these bets paid off, but they would not be penalized if the bets went sour as they were protected by “golden parachutes”.
  4. Very low interest rates from 2001 to 2005 fueled a housing bubble in the United States.
  5. The bankers knew their banks were "too big to fail" (TBTF) which fueled their reckless behavior as they were confident that the government would bail them out if things went downhill.
  6. Irrational investors didn’t foresee that the subprime mortgages would default when housing prices would decline.

Role of GSEs

Though the conventional wisdom blamed the GSEs for the financial crisis because they apparently lowered lending standards, the author provides reasons to think against this. Even though Freddie and Fannie were private corporations they were sponsored by the federal government and this made a substantial difference – they were not taxed, and they were able to borrow money at a much cheaper rate compared to other private corporations. Investors assumed that these GSEs were backed by the federal government and would be bailed out in sour times and therefore were willing to lend money to them at much easier terms. But the GSEs' implicit government guarantee became explicit when they were actually bailed out by the federal government. However, even with the government backing for GSEs, each bank was afraid that sister banks to which it lent money might own so many "toxic" MBS that they would soon be insolvent and thus unable to pay back any loans. The author says that this interbank lending crisis caused a contraction of bank lending into the real economy of businesses and consumers. According to the author, the contraction in bank lending to businesses and consumers accounted for the Great Recession, as each commercial bank, unable to obtain loans from other banks—and perhaps fearful for its own solvency—hoarded cash rather than lending it out.

Deregulation of finance

If the Fed had acted by banning ARMs or subprime lending then the crisis would have been prevented. However, according to this argument the author presents two difficulties. The political objective of Clinton and Bush administration was expanding the middle class by offering homeownership opportunities to the poor. This could be done only by making subprime loans and securitizing them, since securitization was perceived to reduce the risk inherent in subprime lending. It does not seem realistic to lay blame for the crisis on the absence of a ban on the very practices that would achieve the homeownership objectives of powerful political forces. The second argument presented by the author against the conventional reason is that nobody in 1980 or 1982 could have predicted that defaults on subprime ARMs would have caused a worldwide banking crisis when, two decades later, (l) subprime ARMs would be securitized into PLMBS, and (2) commercial banks in the United States alone would come to hold approximately $250 billion worth of these securities, with non-U.S. banks holding an additional $167 billion worth. Therefore it is easier to day that regulators should have banned subprime lending, but political pressures guided towards raising home ownership rates favored both subprime lending and, as a means to that end, ARMs and securitization. Lastly, the author points out that if the amendment of Glass-Steagall by GLBA were to have had any role in causing the recession, then, it would have had to be by allowing the investment-bank arms of bank holding companies to transmit losses to the commercial banks with which some of them were affiliated through bank holding companies (BHCs). The troubled investment banks, therefore, not only would have had to be BHC affiliates rather than stand-alones, but their losses on PLMBS would have had to have reduced the capitalization of the commercial banks with which they were affiliated. However, it is difficult to envision how this might have occurred under the terms of GLBA. Under GLBA, a bank holding company is merely a shareholder in its affiliates; it has no liabilities for their debts, and if either an investment-bank subsidiary of a BHC or the BHC itself fails, the commercial bank subsidiary is unaffected. Moreover, banking law and regulations prevent the activities of a bank securities affiliate (investment bank) or subsidiary from adversely affecting the condition of a related bank.

Banker’s Bonuses

Bank executives received performance bonuses for profits; but if profits turned to losses and the executives were fired, they often had "golden parachutes" to protect them from financial damage. However, the author argues that equity-based incentives which are the preferred form of incentive compensation for executives, tend to favor a longer time horizon, since there is a vesting period of three to five years before bankers receive these bonuses. This should eliminate any incentive for them to deliberately take excessive risk in order to drive up the price of the stock in which they are paid, at least if the risks thus incurred might have the opposite effect on the stock price within three to five years. Moreover, each year begins a new vesting period which means there is added incentive to work every year for the future benefits. There are other countervailing factors such as personal disgrace if an executive ruins the company which will add pressure to their professional future. Further, the author provides two more reasons to substantiate that deliberate risk taking – as alleged was not a significant factor to have caused the crisis. Firstly, if these bank executives were actually “reckless gamblers” then they should have attempted to place their bets with the maximum leverage allowed by law. Prevalent laws required banks fund at least 10% of its investments with their own money. However in 2007, capital levels of 20 largest US banks were nearly 20% above the legal minimum, which implies that the banks themselves had their own skin in the game as well. The second reason to doubt that bankers were deliberately taking excessive risks in pursuit of revenue is that they bought the least-lucrative MBS available—either agency bonds, issued by the GSEs and thus implicitly guaranteed by the US government; or AAA rated PLMBS or CDO tranches. Not only were agency and AAA MBS rated as "less risky" than lower-rated PLMBS bonds; as a result of these ratings, AAA-rated bonds paid lower coupons than did lower-rated bonds. A “reckless gambler” banker trying to maximize his revenue, never would have purchased agency bonds or AAA bonds instead of bonds with higher coupons due to lower ratings. Yet that is what commercial bankers did.

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